Two short weeks ago, we dissected perhaps the most widely-anticipated but least-understood aspect of the Tax Cuts and Jobs Act: the new deduction available to business owners. As a reminder, under the new law, after January 1, 2018, the owner of a:

sole proprietorship reported directly on Schedule C

rental activity reported directly on Schedule E

S corporation, or

partnership…

…is entitled to take a deduction equal to 20% of the “qualified business income” earned from the business.

Qualified business income is best thought of as the ordinary, non-investment income of the business. Stated in another way, this is the revenue the business was designed to generate, less the applicable expenses. So we ignore things like interest or dividend income or capital gains from the sale of property.

The deduction, however, is limited to the LESSER OF:

20% of qualified business income, or

50% of the total W-2 wages paid by the business.

There is also an alternative limitation based on the owner’s allocable share of 2.5% of the unadjusted basis of certain business assets, but let’s cast that aside for today.

If you make your living in the tax world, you know David Kirk, even if you don’t think you know David Kirk.

If you’ve ever applied for a late S corporation election, you know David Kirk. If you’ve ever computed a client’s liability for the net investment income tax, you know David Kirk. And if you’ve ever been wowed by the acting chops on the guy who played Captain Kirk in that Star Trek-themed training video the IRS put out, well then, you know David Kirk.

OK, I made that last one up. But David Kirk is still one impressive dude.

After earning his undergraduate degree at Syracuse, Kirk added a law degree (University of Pittsburgh) and LLM (Georgetown) to his resume before joining the IRS as an attorney with the Office of the Chief Counsel. Within Chief Counsel, Kirk landed with the Passthroughs and Special Industries division, where he specialized in the treatment of partnerships, S corporations, estates and trusts.

While with the IRS, Kirk worked tirelessly to make our lives easier. He authored Revenue Procedure 2013-30 – which offers late relief from a missed S corporation, QSub, or entity classification election — sparing advisors from many a rough conversation with clients.

Kirk’s magnum opus, however, was his work as the primary author of the regulations under Section 1411, the provision of the Affordable Care Act that imposes a 3.8% surtax on net investment income. At a time when practitioners were struggling to keep up with an abundance of new law – the repair regulations, the individual mandate, and the expiration of the Bush tax cuts, to name a few – Kirk’s proposed and final regulations under Section 1411 provided much needed guidance in a way advisors could understand and implement.

On December 22nd, President Trump signed into law the Tax Cuts and Jobs Act, finalizing a once-in-a-generation overhaul of the existing Code and leaving the once-burdensome tax law so simple, we’ll all be preparing our returns on postcards come the spring of 2019.

Simple. That’s rich. I’ll make a deal with you: how about we spend some time diving into just one aspect of the bill — the new deduction bestowed upon owners of sole proprietorships, S corporations, and partnerships — and then you decide for yourself just how simple this all will be?

For those of you who are familiar with the format of a “Tax Geek Tuesday,” you know what to expect. For those of you who are new to this space, what we do here is beat the heck out of a narrow area of the tax law. In great, painstaking, long-form level of detail. The hope, of course, is that we can accomplish what Congress can’t: making the law more manageable for those who need to apply it. Let’s get to it.

Entity Choice Under Current Law

If you want to operate a business, there are four main choices for doing so:

C corporation

Sole proprietorship

S corporation partnership

Owners of a “C corporation” are subject to double taxation. When income is earned by the corporation, it is first taxed at the business level, at a top tax rate of 35% under current law. Then, when the corporation distributes the income to the shareholder, the shareholder pays tax on the dividend, at a top rate of 23.8%. Thus, from a federal tax perspective, owners of a C corporation pay a combined total rate on the income earned by the business of 50.47% (35% + (65% * 23.8%)).

Of course, you don’t have to operate as a C corporation. Instead, you can operate a business as a sole proprietorship. Or as an S corporation. Or as a partnership. And what do these three business types have in common? They all offer a single level of taxation: when income is earned at the business level, it is generally not taxed at that level; rather, the income of the business is ultimately taxed only once, at the individual level.

Neither snow nor rain nor crippling deficits nor a monumental upset in Alabama stays these Republicans from the swift completion of passing a tax bill that few understand and even fewer seem to want.

That’s right; undeterred by nonpartisan proof from the Joint Committee of Taxation that the $1.5 trillion in proposed tax cuts will not “pay for themselves,” and unwilling to wait for Doug Jones, the new Democratic Senator from Alabama, to take his seat and possibly jeopardize their goals, the GOP continues its spirited yet shameful sprint towards the most comprehensive overhaul of the tax law in 31 years.

Let’s review: Last month, the House of Representatives went from proposing 479 pages of legislation in the form of HR 1 — the Tax Cuts and Jobs Act — to passing the bill in a mere two weeks. Not to be undone, the Senate managed to surpass the hilariously-harried pace set by its counterparts in the House, taking its version of HR 1 to a floor vote just days after the 429 pages of legislative text were made available.

The making of many things — from movies to marriages to mac and cheese — can be rushed without adverse consequences. Not so with the tax law. It’s very nature – a complex morass of provisions that interact with one another in nuanced and often unanticipated ways — requires a deliberate approach; something the Senate, in particular, refused to acknowledge. In fact, in such a hurry was the Senate to pass its bill that it asked its 100 members to vote on a piece of legislation that had been radically redesigned just hours earlier; quite famously, the “final” version of HR 1 was replete with margins full of hand-written text and multiple strikethroughs and redactions.

The results were predictably hilarious. While the bill passed by a 51-49 margin, as a result of the numerous 11th-hour negotiations, the Senate managed to make a $289 billion mistake in its drafting of the legislation; inadvertently killing off a tremendously popular incentive — the research and development credit — that it had intended to keep.

After a dizzying few weeks, tax reform enters its final stages. At present, the House has passed its Republican-led bill, while the Senate has done the same with its GOP-led version of HR 1. Now, the two sides will come together, crafting a final piece of legislation that — once it passes the House and Senate a second time — will be signed into law by the President.

As the two chambers go to conference, you may be confused as to which bill to root for. After all, there are a lot of moving parts (many of which you can read about here). Ultimately, unless you have a rental empire, you probably won’t love either option in its entirety; instead, your allegiance will be determined at a more granular level. You’ll pick your preferences à la carte, taking item A from the House bill, item B from the Senate bill, and so on.

But one thing is clear: if you are a fan of education — whether its getting one or giving one — you will be praying for the House bill to die a quick, painful death, because the House’s version of HR 1 declares what can only be described as a war on education.

Let’s take a look at how the House appears to go out of its way to strip every imaginable tax break currently afforded to students and teachers, at every step in the educational life cycle.

As late Friday night gave way to early Saturday morning, the Senate floor was home to quite the celebratory scene. They were all there: Mitch McConnell and Orin Hatch, Rand Paul and John McCain, Randolph and Mortimer Duke, an army of Republican leaders doling out congratulations faster than corporate lobbyists can line pockets, lauding the passing of a bill that paves the way for the largest tax cuts in 31 years.

But don’t let the smiles fool you…the GOP’s work is not done. You see, the Senate’s passage of HR 1 by a 51-49 margin last Friday did not mark the end of the process; rather, the Senate bill must now be merged together with a companion bill that was crafted by and passed in the House several weeks earlier. The two chambers will soon break bread and try to agree on a final bill, which can then be sent to the President, who will formally tweet it into law.

While the GOP’s vision of tax reform is largely uniform between the House and Senate bills, there are some significant differences that will need to be ironed out. Here are a just a few of the items that will have to be reconciled.

As tends to happen this time of year, I awoke this morning to find that a friendly Elf had mysteriously manifested itself in my living room. Only this time, Oscar wasn’t alone. He was toting along something else that, like Oscar, wasn’t here when I went to bed, but that had miraculously became a reality as I dozed: 479-pages of brand new tax law.

That’s right…in the wee hours of the night, as visions of corporate cuts and repealed death taxes danced in Paul Ryan’s head, the Senate overcame the last big hurdle as it speeds towards the most significant tax reform in 31 years, passing its version of HR 1 by a 51-49 vote.

The work is not technically done, however, as the House and Senate must agree on a bill. And while there may be some sticking points — the treatment of pass-through businesses, education incentives, and medical expenses to name a few — the path is cleared for the President to achieve his signature legislative victory and sign a $1.5 trillion tax cut package into law, just in time for Christmas.

Here are a few highlights of the plan:

The top individual rate is reduced from 39.6% to 38.5%, and the threshold at which the top rate kicks in is increased from $418,000 for a single/$480,000 for married filing jointly to $500,000/$1,000,000. Further down the brackets, rates are reduced as well, for full detail, see here.

The top rate on the income earned by owners of “flow through” businesses — S corporations and partnerships — is reduced from 39.6% to a shade below 30%.

The standard deduction is doubled from $6,350 for a single/ $12,700 if married to $12,000/$24,000.

Deductions for personal exemptions are repealed, but the child tax credit is increased from $1,000 to $2,000.

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. A select group of Tax Professionals of WithumSmith+Brown write Double Taxation, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

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Our tax specialists have a comprehensive understanding of international, federal, state and local tax regulations. We work with you to ensure tax reporting obligations are met in an accurate and timely manner, and to minimize or defer the payment of taxes, thereby adding value to your company. Through the use of technology, we stay up-to-the-minute on tax law changes, and know how they affect your business. Through our affiliation with HLB International, we can also assist you in developing cost-effective tax strategies anywhere in the world.